Now Start Watching Interest Rates, Part 3

In the US, perception management is now the key to public policy. Which means
the latest round of money creation and bond buying will only "work" if consumers
and investors fall for what is essentially a con -- the idea that fiat currency
is the same thing as wealth.

If they instead figure out that their savings are being destroyed while their
government's indebtedness explodes, they won't invest in stocks and bonds or
buy new houses and cars.

So everything depends on the marks not catching on, and all eyes are on stock
prices, the dollar exchange rate, and long-term interest rates. Any of these,
by gapping in the wrong direction, can cancel out the psychological impact
of the Fed easing. And then everything falls apart.

How's the con going? Not so well. The dollar's holding up. Stocks are choppy
but remain above their pre-QE2 levels. But interest rates are departing from
the script. It seems that even with all the prospective bond buying, not everyone
is convinced that lending money to the world's most indebted government for
30 years is a "risk free" strategy. Long rates are starting to move up, enough
to warrant two Wall Street Journal articles in one day, excerpted here:

The Fed's latest "quantitative easing" program is designed to bring down
interest rates, but some are moving up instead.

Rates, which rise as the price falls, have risen lately as investors avoid
U.S. government debt--including a new 30-year bond auctioned on Wednesday.
That has generated market anxiety that the Federal Reserve has lost control
of rates and inflation expectations.

But many observers are waiting for the Fed to at least start the program
before making any judgments about it. The rise in yields on 30-year bonds
hasn't been duplicated among shorter-duration bonds, which the Fed says it
will focus on buying, and has been less pronounced for the more-important
10-year Treasury note, which is the benchmark for mortgages and corporate
debt.

"It is premature to say that the Fed has failed or that this has backfired," said
David Ader, chief government bond strategist at CRT Capital. "Logic tells
me that, once the program gets under way and people are selling to the Fed,
that rates will go lower, significantly so."

That is the Fed's plan. The Fed last week committed to spending a total
of $600 billion in freshly printed money on Treasurys before next June, effectively
soaking up all of the new debt issued by the government.

The program of buying Treasurys is designed to keep Treasury yields low,
thereby stimulating the economy and pushing investors into riskier assets
such as stocks and corporate bonds. That's part of the Fed's state goal of
fighting deflation.

The New York Fed will begin buying on Friday with purchases of $6 billion
to $8 billion, according to a schedule released by the central bank on Wednesday.
By Dec. 9 it plans to have bought about $105 billion in Treasurys, including
a handful of Treasury Inflation-Protected Securities, or TIPS.

Having such a big, unflinching buyer in the market should keep prices high
and yields low.

But the opposite has been happening lately. A Treasury auction of $16 billion
in new 30-year bonds on Wednesday was poorly received, with the government
having to pay a slightly higher yield than expected to attract buyers.

The 30-year Treasury bond's price has fallen nearly 12% since Aug. 26, just
before Fed Chairman Ben Bernanke hinted at QE2 in a speech at Jackson Hole,
Wyo. The yield has jumped to 4.239% from 3.53% in that time, and at one point
on Wednesday surged to the highest since May.

And Treasurys have weakened despite fresh fears about European sovereign
debt, which in the past has been a boon to safe-haven U.S. government debt.

It's too early to say what the quick rise in Treasury yields says about
the Federal Reserve's latest policy moves. But they are a reminder, particularly
for banks, that any eventual market turn could be fast, furious and painful.

The yield on the 30-year Treasury bond has jumped more than 0.7 percentage
point since the Fed hinted at more bond buying in late August, of which almost
0.2 percentage point has come since last week's announcement the program
would total $600 billion.

The 30-year bond is a canary in the coal mine when it comes to inflation
fears. Because of their long duration, such bonds are most sensitive to changes
in inflation expectations. They also are receiving little support from the
Fed's buying program.

Wednesday's weak auction for $16 billion of 30-year bonds showed how nervous
investors have become in this regard. If inflation eventually does materialize,
yields could move in an even more significant fashion, leaving many investors
in the lurch. Over the past year, buyers of Treasury and mortgage debt have
held their nose while purchasing ever-lower-yielding paper. Banks in particular
have bulked up holdings of government and mortgage-backed debt due to tepid
loan growth.

Many investors hope, should the rate environment change, they will beat
others to the exit. That's a risky strategy. Shorter-dated bonds also hold
risks, albeit to a lesser degree.

No wonder Federal Deposit Insurance Corp. Chairman Sheila Bair warned in
a speech last month that banks should be able to withstand rate rises of
as much as five percentage points over a two-to-three-year period. That is
extreme. But investors also should be asking themselves if they are prepared
for rapid shifts.

John Rubino is author of Clean Money: Picking Winners
in the Green Tech Boom (Wiley, December 2008), co-author, with GoldMoney's
James Turk, of The Collapse of the Dollar and How to Profit From It (Doubleday,
January 2008), and author of How to Profit from the Coming Real Estate
Bust (Rodale, 2003). After earning a Finance MBA from New York University,
he spent the 1980s on Wall Street, as a currency trader, equity analyst and
junk bond analyst. During the 1990s he was a featured columnist with TheStreet.com and
a frequent contributor to Individual Investor, Online Investor,
and Consumers Digest, among many other publications. He now writes
for CFA Magazine and edits DollarCollapse.com and GreenStockInvesting.com.